← Value Investing with Legends
Value Investing with Legends
Richard Brekka - From Venture to Secondaries: Richard Brekka on Illiquid Market Advantages
01:03:35
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- [00:02]
A
Welcome to the Value Investing with Lanes podcast. My name is Tano Santos, the Robert Hellbrum professor of Asset Management and Finance at Columbia Business School and the Faculty Director at the Hellbrun center for Graham and Dawn Investing. So today I'm not here with my co host Michael Mabison, who is having fun traveling somewhere exotic and thus missing in action. But no worries, he'll be back for the next episode. As all of you know, I teach every year a Modern Value Block Week to the students of the program, which is a value investing class heavy on valuation techniques, economics and competitive strategy, accounting, analysis of intangibles, the overall market, the works. Now it is a class focused on public equity markets which frankly have been the focus of so much of the activity of, I would say, the traditional value investor. I finish that class every year by telling the students that we have focused the course in public markets, which is appropriate. They are large today, more or less the market capitalization of U.S. equity markets about $70 trillion give or take, but that we live in the age in which private markets have grown tremendously and it is difficult to contemplate a long career in asset management without some exposure to an understanding of private markets. Now it is difficult to get to know private markets. Information about individual companies is dispersed, there is very limited accounting information about them, liquidity is sometimes poor and the average investor faces what seems insurmountable problems of adverse selection, which is a constant risk of the poorly informed investor. In what concerns private equity, there are two private markets. There's the private equity markets of the large VC&P firms such as KKR. And then there's the smaller, perhaps a bit out of the limelight market called the private secondary market. Fascinating. Small, about $170 billion. It is a fascinating market in particular for the value investor as the frictions that lie at the foundation of traditional value ideas are operational to an extent that they are not anymore in public markets. To talk about this fascinating corner of the market, I have invited a dear friend, Richard Brecker. Richard Brecker is the CEO, Managing Partner and co founder of Second Alpha, a vehicle specializing in secondary investing. For more than 20 years, Richard has invested in growth oriented tech companies, software as a service, mobile content, communication service and so on. Prior to funding Second Alpha, Richard was president, Managing Partner and founder of Dolphin Equity Partners, a New York based venture firm and between 1990 and 2010 Dolphin raised two funds and invested in nearly three dozen portfolio companies. Richard holds a Bachelor's degree from USC, the University of Southern California and an MBA from the University of Chicago, May alma mater. Now, Richard and I have been friends for many years. We met through our son's school and have known each other then for quite a while. So if this conversation has the flavor of a coffee conversation, well, now you know. Richard Brecker. Welcome to the Value Investing with Legends podcast.
- [03:16]
B
Thank you, Tano. Happy to be here.
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A
That's wonderful to have you. So, Richard, we always start these interviews with a bit of your biographical background. Where did you grow up? What was your background? Family connections to the world of finance. Tell us a little bit about yourself.
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B
I was born in Huntington, Long island, and left as a four year old to Southern California. I am the seventh of ten children, six girls, four boys. We're outnumbered. Grew up in La Jolla. In high school, we moved to Los Angeles. My dad was the CFO of Continental Airlines. So I got a lot of exposure about finance and how business works just talking to my dad. But also I went to a school in Los Angeles where there are a lot of very successful parents in the movie business, in the music industry, and then in general industry in Los Angeles. And I was always curious because my friends lived in these very large houses. My dad did well. But when you divide income by 10, it doesn't go as far as you would think compared to my friends. I would visit my friend's house and end up talking to their dads. And my question was, how did you get this? How did you get a seven acre mansion on the beach in Malibu? And the dad would tell me the story. It came to me that every one of these dads started with one great idea. They took that great idea and they built a company. And out of a lot of hard work, they ended up becoming very successful. So at 16, I thought, all right, I need to come up with a great idea. And someday I will figure that out. One quick example was a dad who wanted to do a national concert tour. Never been done before. He got Elvis Presley, convinced Colonel Parker to let him do it, did a national concert tour, was successful, became one of the biggest tour promoters in the United States and had a great career. That was one great idea. Second great idea was that he was reading an article of a story in the Los Angeles Times of a young man who was getting bullied at school, who decided to go to karate dojo and learn how to defend himself with karate. The article, my friend's dad took to a screenwriter and said, write me a movie. The movie Karate Kid. And then this dad went on to make Ocean's Eleven and a Number of other movies. So he actually had two separate careers, which coming from it all starts with a great idea and then really hard work and some real chutzpah to get that done. I went to USC in Los Angeles. I had a great economics teacher named Arthur Laffer.
- [06:16]
A
Oh, the famous Arthur Laffer. That's quite something.
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B
Art is a great guy. He's very amiable, always joking. And one time I told him my family had moved to Chicago, and he said, well, you should go to Chicago and get your mba. And if people know Art Laffer, he's a real joker. And I didn't think he was serious, so I said, sure, Art, write me a letter. And he said, I will. And if I write that letter, you have to apply, and if you get accepted, you have to go. And I still didn't think he was serious, but he gave me the letter, I applied, I got accepted, and that led me to University of Chicago, where I got my MBA.
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A
What year was this?
- [07:02]
B
I graduated in 1987.
- [07:06]
A
1987. Okay, so four years before I arrived.
- [07:10]
B
Yeah, right. It was a lot of fun, and I kind of knew where my passions were. One of the classes they had at University of Chicago was, you ran a business and you put in the inputs at the end of your class, and then the week after it would tell you how your business did. We did very well on that modeling, but one of our other teams in the class didn't do so well. So I made them an offer to buy out their business with an exploding loan that if they didn't hit their numbers, the next class. My group owned their company. And we had one condition in the class that they couldn't tell the other groups in the class. At the end of the semester, the other people in our class found out that we not only were the largest company in this modeling game, but we also own the number two company as well. That kind of got me going down the track of I want to be investing in companies. I left Chicago, I went to New York, I went to work for Chase. Chase was great training ground to learn how to really analyze businesses and basically learning value investing.
- [08:21]
A
What were you doing for exactly for Chase? What was your job description?
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B
I was in private equity, and I did a project finance transaction, but I was pulled into different projects that taught me a lot about different businesses. One great story is the bank financed a styrene plant that had been shut down by Monsanto. It was a private equity buyout, and the styrene plant was a huge success. And the guy at Chase I Asked, how did you know it was going to work so well? And he pulled out of his drawer a supply and demand chart of Styrene. And he said, they've been oversupply for 10 years. But the supply and demand lines were running toward each other and were just barely about to touch. The business was projected to do about 30 million in EBITDA the first year because the lines hit and the elasticity of demand. Company earned 300 million in the first year, which was the purchase price of the company. And the price went all the way up to the level of the substitute, which was paper cups, because Styrene makes Styrofoam cups. It was hugely successful and the company was sold for $3 billion. I learned a lot. I like working on these kinds of deals.
- [09:45]
A
What is wonderful about that story is the use of simple but powerful economics to understand companies and to understand where they're heading, which is something that I emphasize to the students. I know you do that too. When you come to class, which is very important to understand the basic economics of the business you're studying. That's kind of the starting point and you can still find great opportunities to that way.
- [10:11]
B
I saw Arthur Laffer later in years, I told him the story and I said, I give credit to that understanding from my econ class at usc. It literally was a supply and demand chart. And when I'm looking at any business, we look at that supply and demand balance and where are we on the chart? The other one I did a company called Rouge Steel, which was a steel plant owned by Ford Motor Company. When Henry Ford built Ford Motor Company, the thesis was from iron ore to automobiles all in one location. Rouge Steel had a UAW labor force, which meant no steel company could buy it. So we did a project finance structured deal and we put all the risk back on Ford for environmental, pension, healthcare, and then we've got take or pay contracts. But the problem was Ford didn't have numbers on the plant. So the guy from project finance said, I'm going to do the equity. He said, well, you have to figure out how to model this business. He said, making steel is like cooking dough. You have different ingredients, you roll it, you press it, you cook it, and out comes steel. So we literally built the process and really detailed learning. I was in Dearborn asking for invoices on different inputs in order to actually build the model. And then the last experience that Chase and I'll move on from here was a guy came up from Washington D.C. he was an FCC lawyer, left the FCC and he said, I have an idea, here's a great idea. I'm going to build a third cellular company using taxi dispatch frequency which is actually adjacent to the two cellular companies that exist. And I'm going to buy up all that frequency and I'm going to build a nationwide cellular business. And everybody said, can't be done. And I spent a weekend arguing with the guy why it can't be done. And at the end of the weekend he had convinced me could be done. So we bought the Spectrum from Motorola dealers, these mom and pop dealers who own this spectrum. And all we wanted was the spectrum certificate. They give us their business accounts in a shoebox with checkbooks and that's how they ran their businesses. We collected all this and we built a nationwide network and we took it public and we called it Nextel. Nextel merged with Sprint. This idea of looking for great ideas permeated through my career. I left Chase, I went to cibc. They asked me to start a private equity group in New York.
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A
This is a Canadian bank, Canadian Imperial bank.
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B
And they gave me great autonomy.
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A
Richard, how long were you at Chase? So how old are you when you moved to the Canadian Imperial Bank?
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B
I was probably about 32 when I went to Canadian Imperial bank because I was 36 when I started Dolphin Equity. So I was there for four years and had some great success because I knew Nextel so well, I knew the entire industry. There was a sector of the United States that hadn't been consolidated. I financed a consolidation of the Spectrum in the Pacific Northwest, took it public, sold it to Nextel and in 12 months took a 7 1/2 million dollar investment, turned it into $50 million. The CEO CIBC said I'll give you as much money as you need if you can replicate that every single year. And I said, if you know anything about private equity that is not replicatable every single year, but working in a big bank, there's always a lot of limitations. And I wanted to be more focused in what I was doing.
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A
What are those limitations? What is that you felt you could not do inside this large organization that require you moving in on your own and found Dolphin Partners.
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B
Big organizations, big companies have a lot of politics. And in my case I worked in New York and I ran my little business there investing in the United States. But I was part of a office in Toronto and the guy who hired me, David Cassie, I'm a great admirer of, and he went on to found canaccord Ch ingenuity and then the second person after he moved up was a really smart lady and I really enjoyed working for her. But then banks do things that don't always make sense. The next move was that they took two people that had never done any private equity investing and they made them co heads of the group. I said to David at a dinner, he said, what do you think of our choice of moving two people in as co heads? And I said, well, I think he just hired Dumb and Dumber.
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A
This is something that our audience should know about Richard. He's a very mild minded man, but he speaks his mind.
- [15:19]
B
He said, well, doesn't sound like you're going to stay at CIBC very long. And I said, no, I don't think this is going to work out the long term for me. David and I are still friends. So I decided to go out and start a venture fund called Dolphin Equity Partners. And I went to people that had invested with me over the years and said, I'm starting a fund, I'd like you to support me. Harbor Vest, which is a large fund in Boston, Norwest Venture Partners, omers, which is the Ontario Municipal Employee Retirement Fund, and then Case to Depot out of Quebec were anchor investors. I raised a fund largely by myself and then hired the people to join it. We invested in technology and it was telecom infrastructure and in the early days of the Internet, so this is where life gets hard. We ran into the Internet bubble and the telecom meltdown and had a lot of companies that did not work out.
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A
In the first Dolphin fund we had
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B
Dolphin one, we were able to raise a Dolphin two which did better. But there was a lot of triage in trying to figure out which companies to support, which ones to cut off. I think in one year we replaced 12 CEOs because there were really tough problems and we had to try to figure things out. But it was also a great learning experience. One of the companies that was in the Dolphin portfolio was a company called Gomez up in Boston. And in 1999 it was a dot com darling. Merrill lynch had filed an S1. We didn't quite have unicorns at that point, but it was being valued at $500 million on 15 of revenue, which is basically a unicorn type valuation. It was the darling back then. One year later when the Internet bubble burst, Gomez happened to have all Internet companies as customers. So when the bubble burst and funding stopped, the customers ran out of money and Gomez ran out of revenue and it imploded.
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A
What did they do exactly?
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B
Gomez, Gomez raided websites, is their business and all the websites were paying them. It was a very Attractive business because everybody wanted a rating. But that business basically died. And I sat down with management and I said, what do you got left? Basically, their 10,000 square foot office space was empty and there's 20 people left. They said, well, we have this little business that we'd started where we monitor websites from the end user, where we put software on 150,000 computers, and we can tell whether a website's performing from an end user point of view. In today's world, this is called observability. And companies like Datadog are big in this, as is Dynatrace. But back then, it was a small business, and it was almost looked at as a nice to have. So I took over the company. I financed it. At one point, I owned 80%. I grew the business.
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A
Wait, you took over the company? You became the CEO of the company?
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B
I became the chairman and largest investor. We fired the third CEO, and I made a career mistake.
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A
I love this story.
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B
I went to the men's room, and while I was in the men's room, the rest of the board decided, we need to get a CEO in here fast. And who should we look to nominate or find? And my current business partner said, what about Rich? The rest of the board said, great idea. Where's Rich? Oh, he's in the bathroom. Oh, this is even better. All in favor? Everybody voted Aye. They documented the minutes. They signed the minutes. And then when I got back to the boardroom, they said, hey, Rich, we've solved the CEO problem. We found someone who knows the company intimately and can run it. And I said, that's awesome. Who'd you find? And they said, you. And I said, what? I run Dolphin Equity in New York. Gomez is based in Boston. And they said, well, you're the new CEO. Good luck. Let us know how it goes. And they all got up and ran for the elevator. And I was standing in the boardroom by myself, and I was like, I'm going to have to run this company,
- [19:59]
A
but it's a great experience. I remember the interview with Henry Ellen Bogan of Durable Capital. Many conversations that I've had with Paul. They both run companies, and they all credit that experience substantially in their growth as investors, that you get to see it from the inside, how to actually make a business work. That is an invaluable experience. And obviously, you have to have your IQ and Paul's and Henry's IQ to run it, of course. But it's a challenge that one should not shy away from. From a learning point of view, if it comes to that, obviously.
- [20:34]
B
Absolutely. You also want to make sure you never go to the bathroom during a board meeting. It was a great learning. So Gomez's business model was software as a service to monitor websites for the large web companies. We were growing very fast. We're 40 plus percent growth rate, but we were billing monthly in arrears and we were running out of cash all the time. And I said to the interim cfo, I said, let's run some numbers. What if we just build quarterly in advance? And he ran the numbers and said, well, that would help our cash flow. And I said, okay. Called the whole management team in, and I announced we're going to build every single customer quarterly in advance. Start calling customers, tell them it's going to happen. And the management team thought I was there to kill the company because it said, we're going to have huge churn, customers are going to flee. And I said, well, we're going to run out of cash one way or the other, so we might as well just take a leap. And we did it, and nobody left.
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A
Also, it's a test of the business model of commerce, right, that you're providing a value to your customers. So you're going to test it. If it's really valuable, that will stay with you.
- [21:50]
B
Frankly, back then it was their only eyes on their website to know whether the user is actually seeing what is being put out there. Because websites aren't made in a data room. They're accumulated from all different sources. So that worked pretty well. I said, well, if quarterly works, let's go annual in advance. And of course the management team is throwing their hands up in the air and saying he really is just trying to kill this company. And we went annual in advance and nobody churned. Everybody stayed. When you're growing at 40% a year and you're being paid annual in advance, the money floods in. So we were able to expand our sales force and grow the business and create new products, which is the other leg of the stool. Multiple products is the key to success. You can't rely on one product. So I hired a great CEO named Jamie Ellerson, and he did an amazing job building the business, rolling out nine new products in like 18 months. And we were just becoming the industry leader. I told him, we're going public. We had an S1. He said, well, I'm going to go talk to some strategics. I said, you can talk to them, but don't sell the company. And he said, okay, Rich, I won't do that. And he came back a week Later. And he said, rich, I honestly was just trying to create some strategic business. I have five offers for the company now. We ended up choosing Dynatrace, which is in the observability business. And really the core product of Dynatrace today is Gomez. That was a great experience for me in my career. But what led us to do second alpha was in the last year of owning Gomez, I got a call from a young guy, probably analyst level at B of A in Charlotte, who said, my boss walked in my office today and put a box of stock certificates on my desk. And they're all private tech companies. And he said, one of the certificates is Gomez. And I said, well, where'd you get the box? He said, well, B of A bought Fleet bank in Providence. Fleet bank bought Bank Boston in Boston. And Bank Boston had a venture group, and when it was shut down, their investment portfolio and all the stock certificates were put into a filing box. And it landed on my desk. And my boss said, call people and get offers. And I asked the guy, I said, well, what exactly did your boss instruct you to do?
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A
This sounds like a very dangerous conversation.
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B
I was instructed to empty the box.
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A
Oh, that's wonderful.
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B
And I said, okay, I know what I'm going to do. I said, first of all, I'm not a secondary buyer. I don't do this for a business. I'm a venture capitalist. I build companies. And he said, well, I have over 100 stock certificates to call people. I don't have time to go find another buyer. The second mistake on his part. And I said, all right, well, I'll pay you what I paid for my shares nine years ago. When I first recapped it now There was an S1 on file so he could see our numbers. And he said, that's a terrible offer. And he said, what do you think I should do? And I said, hang up the phone and call somebody else. He goes, I don't have time for that. Put it in a purchase agreement and email it down to us and I'll give it to my boss, let him decide. They never called back. They emailed the signed purchase agreement with wire instructions. They sold us the shares. Gomez was the big success in that Dolphin fund. For the primary investment we made, we had about 7 million invested in Gomez. We sold it for our share was just under $100 million for a nine year investment. It's a great venture story, but the secondary made the same multiple in six months. We decided and started talking. Jim Sanger, who's my current partner, who was on the board of Gomez with me and said, why aren't we doing secondary investments? Because we just spent nine years of our lives trying to get Gomez to be successful. And then we buy something and we turn it around six months and we make a tremendous return. So that led to starting Second Alpha.
- [26:29]
A
Can I link it back to your childhood story of going to these wonderful Malibu houses and talking with that of your friends, of your school friends, this seeing a good idea and having the courage to pursue it all the way to the end? In a way, this is a general lesson in, not just for investors, but for academics. One of the things that if I can bring one thing that Bruce Greenwald told me once, that most people don't have the courage to follow whatever insight, whatever idea they have all the way to the end and really exploit and analyze the implications of that idea. And I think this is a very important lesson that sometimes you stumble upon these gems, so to speak, of insights, and people look at them and they recognize maybe the value of the idea, but they don't have the courage to pursue them all the way to the end, which I think is what characterizes great scholars. I learned this from Gary Becker, the Nobel Prize winner in economics, who told me the story that when he started working on these topics, the Rational Approach to Human Behavior, that dissertation on the economics of discrimination, nobody had faith in him, but he had enormous faith in him. And of course, he changed social sciences that way. Great investors with their ideas. It's a fundamental lesson that particularly young people who still have all the time in the world to follow on those ideas should consider. But let's go back. I mean, I just wanted to make a point of emphasizing that because I think it's a wonderful story.
- [28:02]
B
There's a great story in that, and it's very, very true. The relationships you build over your career are going to have a tremendous impact on your life. When I left CIBC to go start Dolphin Equity, I had a certain amount of cash in reserve and gave myself a certain amount of time to get to a first close. I'll never forget it. I was in Chicago for a board meeting and another investor was on the board. He and I were having breakfast together, and I said, I'm running out of cash. I don't think I'm going to be able to get this fund raised or get to a first closing. I think I'm just going to have to go home and tell my wife that we got to sell the house and I have to go find a job somewhere, go back to a bank because I've used everything I've got. And he said, why don't we meet after the board meeting and let's chat a little bit more. And we sat down and he handed me a personal check for $50,000. And this is like 1990. And he said, don't give up. I believe in you. I think you're going to get it done. Only cash the check if you absolutely have to. I went back to work and talking to investors and getting to a closing and I got the fundraise and I called him up one day and said I still had the check, I didn't cash it. He goes, yeah, I know you didn't cash it because I was watching my bank account. And I said, what should I do with the check? And he said, oh, just tear it up. One of the biggest mistakes of my life. I should have framed it in loose sight, of course, because it would have been a great reminder of how people can influence your life and your career and so many things. That person had faith in me that I was going to be able to build a business and wanted me to keep going. You also look for this when you meet people where you can give back and say, if I can help you, I will.
- [30:14]
A
Absolutely. So before we get into the second half, I think it would be important, Richard, to give kind of an overview of this market in which you operate, if you don't mind, just to put everyone into this. So why don't you tell us a little bit about an overview of secondary markets and the different categories and what exactly is the space in which Second Alpha operates? Give us a sense of the magnitude what happens in that market when we talk about secondaries.
- [30:43]
B
Most people think in the private market that you're talking about an LP selling his interest in a fund to another investor, because that's what was largely the secondary market. Harborvest Partners was one of the biggest players, or is one of the biggest players in the secondary market. Friend of mine, Fred Maynard was the one who started that business at Harborvest 30 years ago and built it. It created liquidity for limited partners in private funds. So if you're an LP and KKR or Blackstone or anybody Carlisle, and you want to sell your LP interest, you can call a handful of different firms and they will give you a price on that fund on the phone at the moment. And so that was really where liquidity started in the private market. As you go down the list of less well known funds, whether they be buyout or venture, the discount gets Bigger. There's a trading market for funds that way. Then because of lack of liquidity in the private market, general partners start saying, my fund has gone past its natural life. Typical private equity fund, it's 10 years and you get two extensions before you have to go back and start negotiating with the LPs. So GPS started looking at, well, maybe I can refinance my existing limited partners and create a new fund. The model is called the GP LED fund, or people here call the continuation fund. That allowed for the companies to continue to develop at a pace that they're going to grow at and for the GP to get the best value from those portfolio companies. So those are two big areas of secondary that you'll hear about. What is a much smaller part of the market is secondary direct. And what that is is you're buying the shares of the private tech company. Doesn't have to be tech, but most of the market is you're buying the shares from another shareholder in a private company. That market is probably less than 10% of your overall secondary market.
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A
How big is this secondary market? More or less. What is the magnitude of the market that we're talking about is 150, 160 billion. Is that more or less?
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B
2024 was 165. I think this year they're estimating about 180 billion. Pretty good sized market in the secondary direct market. It is very concentrated and illiquid as well. There are some platforms. NASDAQ private market is probably one of the largest. Tom Kelly and the CEO there is a friend of mine and we're talking about the overall market and he said most of the trading is in the 10 largest names, like the public market that has its magnificent seven. The private market has a top ten. And they're the names you would think of. OpenAI, SpaceX, Stripe, Databricks, Anthropic.
- [34:03]
A
So the large private companies are the ones trading in that platform, effectively.
- [34:08]
B
So that's most of the private secondary market. After that are the rest of the unicorns Companies over a billion dollar valuation. Deca corn companies, over $10 billion valuation. That's most of the secondary market. You get down to companies with under a billion dollar valuation and there's very little liquidity for those companies. This is an area that we identified and said there is very little liquidity. And if a shareholder needs to get liquidity on their stock, there aren't many buyers. So we decided to specialize in that sector of the market. And it's been very successful because we have found that there are not many buyers in the market. And despite having trading platforms like NASDAQ Private Market or Forge Global or Hive Markets, when you talk to them, sometimes there's only a handful of buyers. In our case, we have found where companies where we already own a position that we are the only buyer of that stock.
- [35:21]
A
That's an incredible advantage. Of course, something that of course I'm sure will be in the audience mind when listening to you is this issue of sourcing. How do you get to know the investable universe? That's kind of an important side of your business, of course. And I don't want you to divulge any secrets you're not comfortable divulging, of course, without saying. But how do you build a database that allows you to locate potential ideas?
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B
We've always run large databases. We collect data from a number of different sources. Of all the private tech companies, our business is focused on the United States. We do a little Canada, but mostly United States. So we collect the data on all the private tech companies in the US And Canada and we track them and we track as they develop and they get to scale. And what we've learned is that companies that we're looking for are typically over 10 years old. They raise the capital they need financing risk has been eliminated because they turn cash flow positive. And we have this big data set and we've been building and adding to it and data that we can API into our platform and then data that we get from meeting companies and it all aggregates into this big data platform. Then what we did, and we've been doing this since 2015, we have the S1 filings of every tech company in the US that's filed an S1, and we collected all the data from those companies.
- [36:59]
A
Maybe it's worth reminding our listeners what an S1 is. It's a filing that you do before the IPO, presumably because you're thinking of doing an IPO. So you're giving notice to potential investors that you're not committing to an IPO. You can withdraw the IPO, but you have the S1 filing with some basic financials and description of the business. Did I get that right?
- [37:19]
B
Absolutely. The S1 is a moniker that the SEC puts on it is the IPO document. And in that document there's a lot of data, financials for three years, a lot of different data on the company, the development, how much cash that was raised. So we take that data and we pattern match the Companies that filed S1s to the companies in our private database and we're looking for companies that look similar. One of the things we look at on the S1 database is what was that company doing three years earlier? We know when it filed what the revenue is. So let's say it was a 150 million in revenue on filing, but three years earlier it was at 50. So we look for companies that have the growth trajectories, have the capital efficiency. It's about a 50 attribute model that we built. And so we pattern match our database and we get several hundred names, companies that we think fit with what we're looking for. Our typical company is 10 years old, 100 million in revenue, cash flow positive, growing over 30% has certain attributes. So we go through those private tech companies, we separate out certain sectors we don't like and so forth, and, and we get it down to what we call the second Alpha 200 list. And those are the 200 companies we want to meet. And at this point, that's where technology and AI and research can only take you so far because all this work
- [39:01]
A
you've done so far is AI supported, allowing you to cross match, cross reference, compare, analyze. And now you have these 200 list. And now that's your little pond on which you're going to be selecting some names to approach, I guess. So can you walk us through that? So now you have these 200 lists, you have to select one. So how do you select that one and tell us a little bit about that process of contacting the company and see whether they would be interested in going into business with you, so to speak.
- [39:31]
B
We always want to talk to the CEO. It's one of the early learnings that if you talk to anybody else, you're not going to get the answers or the information you need. So we always want to talk to CEO and we go to a lot of tech conferences and we meet CEOs there. We use our network on LinkedIn. I'm usually one degree separation from most CEOs. So I know somebody who knows that CEO and we'll schedule to have a conversation with the CEO. A lot of times it's at a conference because it's convenient, but other times it's over zoom or it's in person in New York or if I'm on the west coast, we'll do it there and we'll sit down and talk about his business. We're really wanting to learn how well his business is functioning and is he executing the way we think it needs to be to be successful in the next couple of years. We're Also looking that the CEO is looking to exit in the next couple years. You will find a CEO who says, I'm going to be a billion dollar exit. And said, well, how long will that take? Says, doesn't matter to me how long it takes. I'm going to be a billion dollar exit. That doesn't really fit our model. We're looking for three to five years and we don't want to be in for 10. We go through that, we figure out if it fits, and then we shift the conversation to the shareholder base and say, you're a 10 year old company. You have founders who founded the company. Some are there, some are not. You have angel investors who put money up to help get it started. You have the old early venture funds that took it into the second round. And then you have a whole series of other funds that have invested, including the last round where your growth equity investors came in two or three years ago. So you've got this pretty diverse shareholder base over a long period of time. Is there a shareholder that needs to get liquidity today? And the CEO will invariably say, yeah, there's a guy. You're not going to want to do this rich. And I said, why wouldn't I want to do it? And he said, because he's small, he doesn't need a lot of money. His needs are half a million dollars or something like that. And my answer always to the CEO is, I'll take care of the guy for you. And the CEO says, you take care of this guy for me, I'll give you whatever you need.
- [42:04]
A
You keep having these conversations that are incredibly yummy.
- [42:08]
B
It's fun because I always say we're a solution provider. And for the CEO, I'm just taking care of a problem, not a big problem. It's not high on his list. It's a problem that they've not been able to solve. So he says, okay, what do you need? I said, well, I need information. I need access to your management team. He said, check, check, no problem. I need information rights. I have institutional limited partners. I can't invest without information rights and all that. And he says, not a problem, I'll take care of that. I need you to waive the company right of first refusal. Company has a right to buy these shares. He said, if I was going to do that, I would have already done it. So that's not a problem. I will waive the right of first refusal. I said, great.
- [42:51]
A
It's important to dwell on this for a moment because I think there's a Very interesting. You're going to do a lot of work of finding the actual value of these shares of this company. You obviously are going to make an aggressive offer to the shareholder that needs this liquidity. It's important that you limit the free riding component of this that the company can always. So this is why this institution is so important. The. How do you call it, the Rofer, the right of first refusal is in place before you actually start the entire process.
- [43:27]
B
Yes, this is one of the keys because we don't want to waste our time just to have the company Rofer or an investor roe for the shares. And we say, okay, great, you waive the company Rofer, that's great. I need you to get your investors the waiver Rofer. And he said, well, that's a lot of people. There's a lot of people on the investor rights agreement. I said, well, if you look at your investor rights agreement, the waiver of the agreement is only 50.1%, simple majority. So who represents 50.1%? And he goes, well, those are probably three guys on my board. I said, okay, go ask them if they want to sell their shares. And he said, you haven't done any work. You haven't told me a price. And I said, it's not the question you're asking those investors. What you're asking them is, do they want to buy half a million dollars with the stock? And for a fund that has to go to an investment committee will largely say, it's not worth my effort. And by the way, this is in fund four and we're investing out of fund six. And so we're not cross investing funds. So we've moved on. We don't see Rofers as an issue when we do it this way. And so he goes to the investor and says, I've got this investor who's willing to take care of this guy for us. It's small. Do you want to exercise a Rofer? And they go, well, what price? And he said, I don't know. And he said, but that's not the question. The question is, do you want to do a small piece like this? And the investor goes, no, I don't want to do that. It's not worth my effort. And he calls the other two or three investors and he gets the 50.1%. And what I learned was, I don't need it in writing. I just need them to give their word to you as CEO that they're not going to grow for the stock because their word is good enough and doing it, in writing, is just going to slow it all down. That happens. And then the CEO introduces me to the seller.
- [45:27]
A
And have you ever had the experience of someone going back on that verbal promise?
- [45:32]
B
One institution, try it. It was a really interesting reaction from the CEO. He told me the story. He said, the institution, once they came to the board to get the waiver of the roer and they found out the price, that investor goes, wait a minute. I didn't know that they were going to buy these shares at such a low price. I'm changing my mind. I'm going to exercise my Rover. And the CEO looked at him and said, no, you're not. And the investor said, yes, I am. I have an agreement. Right here is my agreement. I'm going to exercise my roer. The CEO said, no, you're not, because you gave me your word. I gave my word to Rich, and we don't do that here. He said, and if you really want to push it, go ahead. And next time you want something from me, the answer is no. And the investors said, this isn't worth it. And the CEO said, hey, if you really want to get another piece of the company in the secondary, the next time something comes up, I'll tell you, not this one. This is done. And then CEO introduces us to the seller. We work out a deal. We come to terms. A lot of times sellers aren't selling everything they own. They're just selling what they need to pay for a life event, college, house, divorce, investing in a new company, whatever the life of it is.
- [47:00]
A
Yeah, we call those idiosyncratic liquidity shocks in academia. It's a very sophisticated way of saying you need to pay the mortgage, you need to send the kid to college, and so on and so forth.
- [47:11]
B
Exactly. We work out a deal. And what I found is if you can work out a deal with one shareholder, then other shareholders will sell. I always thought getting an MBA was really important. I actually think getting a degree in psychology is as important because you need to understand the psychology of people. Once we get one seller to sell, it's almost word of mouth. Other sellers come up and say, I want to sell. And they'd say, okay, well, here's the price, Joe. The other seller sold at this price, and that's our price. And they may hem and ha a little bit, but invariably they transact. And so we go from one small purchase and we just keep aggregating over months, and eventually we end up with somewhere in the 10 to 15 million dollars position at a very good price
- [48:03]
A
in A particular company. Can I ask you something that I actually don't know? What is the target size of your fund in terms of assets under management? When you have a fundamental how much capital you want to invest and how many companies are you shooting for?
- [48:16]
B
So the current fund is 170 million and we currently have 18 companies in that fund. We plan to add two more. 20 companies in a fund gives you enough diversity in the portfolio and then we look to diversify across different sectors of technology and then limit the dollar amount for each company. So no company is more than 10% of the fund.
- [48:44]
A
So it's mostly tech. Even though diversified within tech, you basically risk manage through size positioning not to have more than you said. 10% of any fund invested in a single company. Tell me a little bit about the exit and how you see your exit strategy from these funds and how you return your capital to your investors and to yourself, of course. How do you work that process out?
- [49:12]
B
In the first conversation with the CEO, we talk about the business and what he's doing and where he's going with it. In that first conversation, we talk about what his exit plan is. Because it's really important to understand this. If a CEO says, well, I'm just running the business and I'm just growing it and I'm focused on that, it's not an unfair answer, but it means that he really hasn't thought it down the road far enough. If you're looking to sell a company, you need to start building relationships with strategic buyers that you will have a commercial relationship with. And by building those commercial relationships, when you do decide that you're ready to exit, if you're going to do an M and A exit, you have the first phone calls to make right there.
- [50:04]
A
You want to have the CEO focus on what needs to happen for that M and A exit to take place. What kind of things do I need to do to make myself attractive to the strategic buyer? That's what you want to hear.
- [50:16]
B
One example, we had a company called Touch Commerce in two years before we were going to engage in an M and A process. Talked to management and said, why don't you start working on building some relationships? And so they built commercial relationships with nice systems and Nuance, which was bought by Microsoft. And when we actually hired the investment banker, and this is always fun because investment bankers, you hire them and you as the board will look at the investment banker and say, who do you know who you think will want to buy the company? And the investment banker will say, who do you know and who do you think will want to buy the company? And what relationships does the company currently have? And the first thing they did is they called up the first two names on the list and said, we understand you have a relationship with this company. We're being hired to sell it. If you want to own it, then you better put a very strong offer on the table. And the company sold very quickly. So you build that. If you're building it toward an ipo, you have to have at least the first year of quarterly earnings reports in the bag. That is predictable. And if you can't predict your first 12 months after IPO, you shouldn't IPO. You have to know your business so well and have enough in your back pocket, so to speak, that you can deliver either meeting or beating estimates quarter after quarter after quarter. Frankly, it takes a whole different way of running a company at that point versus running a company as a private tech company.
- [52:00]
A
What fund is Second Alpha now in? How many funds have you put in?
- [52:03]
B
This is fund five.
- [52:05]
A
Just to close this segment on Second Alpha, and I want to ask you a couple of questions about private and public markets, which I think would be of interest to the audience. But is there, like a typical company that you can take us briefly, that exemplifies Second Alpha from the previous funds that you thought, look, this is like a textbook example of what we're shooting for in one of the previous funds that you thought this Exhibit A of what we're trying to do.
- [52:30]
B
One company, I believe, you know, the CEO had a great idea. It's been at it almost 13 years. And the idea was that the mobile phone number was the better identifier of an individual than an email address. So he built a business and they went to the banks and all the banks signed up. They have 19 of the 20 largest banks in the United States, and all the banks signed up and it became a pretty sizable business on that. They use it to verify if you're doing a transaction on your phone that you are who you are. And they have all different mechanisms that they're tied into the fabric of the phone networks so they actually know when someone changes a phone or doesn't move or something like that. And they know that longevity on a phone number is an indicator of valid phone. And they built that business and very successful. But like many companies, you have to look at, where do I go next, what do I do to expand? And what I liked about this company is they started looking at other services and they said, well, Uber has a problem that the drivers sometimes get attacked at night by passengers. So Uber actually signed it up and said, we want to identify every single mobile phone. And on your Uber app, there's a blue check mark that you've been validated. And a lot of Uber drivers, if that blue check mark isn't on the screen, they'll turn down the ride because that means that person can't be validated as that person and their credit card can't be validated. And so it's been a huge success, and they've rolled it out with Uber all across the United States, and that kind of leads you into all kinds of other businesses. So obviously Uber did it, so Lyft had to do it, and then all the delivery services wanted to do this. It just keeps expanding. And what I like about this kind of business is, you know, it started off with just the banks in the US Then it expanded into other verticals, and now it's going globally.
- [54:46]
A
And how do you end up with the equity of this company?
- [54:49]
B
I did a secondary purchase initially, a small one, when the company was 40 million of revenue, and last couple years we've been buying and aggregating and adding on to that position because we think it's just such a great company, it will eventually have its exit.
- [55:08]
A
What's the name of the company, by the way?
- [55:10]
B
Prove Identity.
- [55:12]
A
Proof Identity.
- [55:13]
B
You know Roger.
- [55:14]
A
I know Roger. I see. I bet. Roger. Excellent. Richard. I didn't want to finish this conversation without asking a question that comes up often in class, and I wanted to have your thoughts on it, which is the relation between public and private markets, and in particular, a little bit of a policy question, this push to give access to, say, 401 s to private assets. And I wanted to have your thoughts on this matter first, about valuation benchmark between public and private. What is that you can tell us about that and how you think about that problem and that other issue about granting access to particular vehicles like 401ks to private assets and the type of things that you are seeing in that space.
- [56:04]
B
Well, the Jobs act had one major effect, which was it changed the number of shareholders a private company can have. So I think it was limited to 500. I believe it's 2,000 shareholders today. That's a factor in who can own stock in a private tech company. I think that for 401k plans, doing it through a large money manager, whether it's Blackstone or somebody like that, where they have the expertise to do the research and diligence on these companies and then put it into a portfolio of private tech, private companies and give the diversity and safety of that kind of platform makes the most sense. I don't think it's always wise for an individual investor to go out and buy a single private tech company and put it in their 401k. You don't have the capability to understand the company.
- [57:11]
A
This is absolutely fundamental. You need to have that screen expertise, that evaluation expertise that is absolutely key to operate in this market. And this issue of valuation, the benchmarking between the public and the private market, how do you see that problem or advantage that you don't need to sometimes mark to market your positions in private? When you have a private exposure, you
- [57:33]
B
value your companies on a regular basis in the private market based on the benchmark of public comparable companies. The bigger concern, we've always been a discount buyer. So over the history of the firm, we pay around two and a half times revenue of the business. That's a benchmark we use. The public market comparables shot up to about 17 times revenue in 21. And that was driven by the Fed, a massive expansion of the government and then having to fund that. When you expand that quickly, the money had to go somewhere. And so it went in stocks and real estate because bonds had no.
- [58:17]
A
And there's no spillover to the private transaction market.
- [58:21]
B
In the private market, we saw prices shoot up where private tech companies were getting valued at 15 to 20 times revenue. We looked at that and said we don't think that's sustainable. And sure enough, when the Fed realized that by flooding the market with capital that they had ignited inflation, they grabbed the emergency brake and pulled it really hard and pulled back money supply. And then the market multiples all fell back to normal. And so anybody that was buying in the private market was frankly overpaying at that time. You do have to be cautious.
- [59:03]
A
So we're getting to the end of this fascinating interview, Richard, as I know it would be. And we always end up with two questions. Let me ask mine and then I'll ask Michael's question, which is what worries or keeps you up at night with excitement? Richard, looking forward, what is that you think is something for us to think about? And it can be anything. It can be about the world, it can be about markets. What excites Richard Brecker?
- [59:31]
B
I'll leave the New York mayor election alone right now.
- [59:35]
A
That's exciting. It's going to be fun to be in the city in the next few years for sure.
- [59:42]
B
Exciting, scary. All the above, what I look at. And it's exciting and it's scary at times is companies are constantly changing, markets are constantly changing. We're in the middle of another revolution with AI and how AI impacts each of the companies that we're invested in. We just did our annual meeting and we're talking about what AI does in each company. How does it apply? Where is it important? We're not buyers into unicorns, so obviously we're not an owner of OpenAI or any of the big names like that. There'll be winners and losers in that marketplace. There's going to be a lot of effect on businesses and how they operate, and I think it's going to bring a new level of efficiency. This is our modern industrial revolution occurring. I think it's going to be fascinating. I think companies have to stay very agile, and I think they'll find the ones that are agile and adapt quickly will be very successful. Those that stick to the old ways may find themselves obsolete.
- [60:59]
A
One way you can think about it is that AI really brings down that marginal cost curve because it's going to substitute for enormous amount of very expensive skills that before came people with very smart, whatever, managers, tech people, and now you can have your own AI doing things for you. It's worrisome from a labor market point of view, obviously, and it's going to be painful, that technological adaptation that will need to happen. But boy does it usher, as you very well put it, this industrial revolution, this new age that is coming our way. And always our last question, any recommendations for our listeners in terms of what are you reading these days? Something that was formative to you? What are you listening to? Are you listening to any podcast other than the Value Investing with Lanes podcast? Of course.
- [61:49]
B
Always this first When I finished yours, one of my favorites is acquired, of course. Great podcast, great podcasts, fascinating stories, very well researched and a lot to learn from. And then I like reading the Warren Buffett book. He's a great example of value investing. I was planning on taking my son out to Berkshire's annual meeting and I just couldn't make it work. I said, well, we'll go next year.
- [62:20]
A
Let's go next year. Our sons are very good friends. Let's tell this to the audience. Rich and Lucas are very good friends. So let's bring them together. They will have a blast.
- [62:29]
B
I think that'd be awesome.
- [62:31]
A
Absolutely.
- [62:31]
B
I know Warren says he's retiring, but he likes to talk, so he will probably be there as a guest speaker.
- [62:39]
A
Probably now, even more. Absolutely. Oh, that sounds like a great idea. So you recommend Buffett's letters and books. Yes, the guy is a goldmine when it comes to this. That's wonderful, Richard. So, Richard Brecker, Founder, Managing Partner and CEO of Second Alpha thank you so much, Richard, for coming to the Value Investing Williams Podcast. It's just been phenomenal fun as I knew it would be.
- [63:03]
B
Thank you, Thiero. I always enjoy it.
- [63:05]
A
It's a lot of fun. And to all of you, thank you so much for tuning in and we'll see you in the next podcast. Thank you for listening to this episode
- [63:15]
B
of the Value Investing With Legends podcast. To subscribe to the show or learn more about the the Halbrand center for Graham and Dodd Investing at Columbia Business School, please Visit Graham and Dodd.com thank.
- [63:34]
A
You.